Consider the following two strategies:
Strategy 1: Purchase one unit of asset M, currently selling for $103. A distribution of $10 is expected one year from now.
Strategy 2: Purchase a call option on asset M, currently selling for $3. The exercise price is $100. A distribution of $10 is expected one year from now.
The difference between the two strategies is that the investor would be obligated to pay $3 for the call option on asset M in Strategy 2, whereas there is no such cost in Strategy 1. However, Strategy 2 has the potential to provide a much higher return on investment than Strategy 1. The option buyer has the right, but not the obligation, to buy or sell a specific asset at a specific price. In this case, the call option buyer has the right to purchase asset M at the exercise price of $100. If the market price of asset M rises above $103, the investor will be able to purchase the asset at a lower price than the market price, resulting in a profit. However, if the market price of asset M does not rise above $103, the investor will lose the cost of the call option, which is $3. Thus, the potential return on investment is higher in Strategy 2, but so is the risk.